Single-Tenant Net Lease Retail Cap Rates Rise With Interest Rates

Cap rates for the single-tenant net lease retail sector increased by five basis points in the third quarter to 6.25 percent, reported Boulder Group, Northbrook, Ill.

"This represented the third consecutive quarter of increased cap rates for the single-tenant retail sector," said Boulder Group Senior Vice President John Feeney. "The upward trend of cap rates should remain as the Federal Reserve continues to implement its monetary policy objectives."

Marcus & Millichap, Calabasas, Calif., agreed the single-tenant net lease retail sector could be "substantively impacted" by the Fed's interest rate increases because these assets typically respond strongly to the 10-year Treasury rate. "This will coalesce with other components such as brand, location and lease terms when determining going-in cap rates," the firm's Net Lease Retail Report said. "For example, dollar store yields can vastly differ as a number of these assets are in rural locations, providing potential for higher returns. Conversely, yields for convenience stores and quick-service restaurants typically maintain a much smaller range due to their tempered sensitivity to key determinants of cap rates."

The sector's sales transaction velocity eased modestly over the past year as investors awaited details on the new tax law. "With much of that uncertainty now relieved, sales activity could accelerate," Marcus & Millichap said. "Furthermore, decreased taxes on pass-through entities could lead to repositioning efforts, bringing more assets online and elevating market liquidity."

In addition, the new tax law retained the 1031 exchange, which is a popular practice for single-tenant net lease property investors. "Investors favor this tax provision to swap out management-intensive assets for properties that involve a more passive approach while deferring the capital gains tax," Marcus & Millichap said.

Boulder Group noted demand for assets in the net lease sector remains strong, "so pressure on cap rates comes from upward movement in the 10-year Treasury yield," the report said. The 10-year treasury yield peaked at 3.10 in the quarter, its second-highest level since early 2014.

"The rising rate environment has had the greatest effect on cap rates on properties with no rental escalations, weak credit and properties in secondary/tertiary markets," Feeney said. "Furthermore, assets priced above $12 million that typically are sold to institutional buyers experienced significant cap rate increases."